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Piketty and Emerging Markets

Much has been said to refute Thomas Piketty’s important book, Capital in the Twenty-First Century, from the perspective of developed countries, but not from the standpoint of emerging markets. His contention that the rate of return of capital, roughly twice the rate of growth of the economy, leads to increasing inequality is not consistent with what has happened in the developing world. His notion that the economy is destined for a modest rate of growth and that the capitalists’ share of aggregate income will increase at the expense of workers runs against the evidence coming out of up-and-coming economies.

Before I get into that, I remind readers that various Austrian School economists have exposed significant flaws in Piketty’s understanding of the value of capital and its relation to the return on capital. Randall Holcombe states that the French author gets it backwards when he makes the return on capital dependent on the starting value of capital. It is by discounting the expected return generated by capital goods in the minds of entrepreneurs who combine them productively that an estimate of the value of capital can be reached. Since the discount factor depends of the rate of interest, the same capital goods can have very different values depending on the environment. And the aggregate value of capital doesn’t tell us how many ventures failed.

Spanish economist Juan Ramón Rallo, for his part, has shown that the rate of return of capital is not the same as the rate of growth of the income generated by capital. It is perfectly possible for the rate of return to be greater than the rate of growth of the economy, and for the ratio between capital and income to be fairly constant throughout the ages, as Piketty himself demonstrates while drawing the wrong conclusion from his data.

None of this disproves that inequality has grown in certain periods. In fact, Piketty shows that the years leading up to the Great Depression and the Great Recession were two such periods. But given that the rate of interest was in both cases manipulated by government, the inequality derived from the increased value of capital was a by-product not of perverse free markets, but of monetary interventionism.

These flaws help us understand why Piketty has not paid enough attention to what the emerging world tell us in relation to capital and income.

Three decades ago half the world population was living on less than $1.25 a day; today only one-fifth finds itself in that condition. About 12 percent of the population of Latin America and the Caribbean were extremely poor at the end of the 1990s; the percentage is half of that today. The key is to be found in the rise of the so-called middle classes. Thanks to Latin America’s increasing role in the world economy (though still rather modest), the number of people who fill the space between the rich and the poor has grown impressively—according to some estimates, by as much as 50 percent in the new millennium.

Part of this was due to economic growth and part an effect of income redistribution. We don’t need the many studies that place the main responsibility on the former to conclude that investments seeking a return were crucial. The countries that invested less and redistributed more, such as Venezuela, are the ones where the middle classes have been hurt the most in recent years. In Chile, Peru, and Colombia, where the rate of private investment has reached 20 to 25 percent as a percentage of GDP, they have expanded. Only 14 percent of Chileans are poor, and the percentage of poor Peruvians has dropped almost by half since 2001. The capital invested produced value, which generated jobs and better incomes for millions, which led to an expansion of the middle classes. And what did they do? They got their hands on capital, of course, to create even more value.

According to Piketty, about half of the total value of capital is linked to housing in developed countries. Since people in emerging countries are not Martians, they have also sought to own property. And not just houses: in many countries, they own stock through private pension accounts. Their assets have generated income, part of which has been reinvested and the rest consumed. When they reinvested capital, Latin Americans did not stop to think: What fraction of the national income am I going to lay my hands on, and how is my rate of return going to compare with the rate of growth of the economy? Instead they risked their wealth in all sorts of ventures expecting to earn more than the cost of capital. The spurt of new businesses in the outskirts of Latin America’s main cities opened by the children of poor rural immigrants attests to this.

Exactly what the value of the capital they own is depends on the expected future returns discounted by the prevailing long-term interest rate. What is clear is that, where there were once a few fat cats and a mass of poor people, there is now the product of social mobility. Exactly as happened in the developed world after (relatively) free markets were allowed to do their job in the past couple of centuries.